The demand curve and supply curve for one-year discount bonds with a face value

Question

The demand curve and supply curve for one-year discount bonds with a face value of $1,000 are represented by the following equations: Bd: Price = -0.06 Quantity + 1140 Bs Price = Quantity + 700 suppose that, as a result of monetary policy actions, the federal reserves sells 80 bonds that it holds. Assume that bond demand and money demand are held constant. a. How does the Federal Reserve policy affect the bond supply equation? b. Calculate the effect on the equilibrium interest rate in this market, as a result of the Federal Reserve action.

Explanation / Answer

Selling more bonds should increase the supply of bonds in the economy (which will reduce equilibrium prices and increase the equilibrium interest rate) Bs : P = Q + 700 We need to add 80 bonds to the supply of bonds. Rearranging the equation, we get the that quantity supplied of bonds is given by Q = P 700 Adding 80 bonds to this gives: Q = P 620 Thus the new bond supply equation is P = Q + 620 (ii) Q + 620 = 0.6Q + 1140 Q = 325 P = 325 + 620 = 945 945 = 1000 i = 0.058 = 5.8% 1+i 3

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